Quantitative easing and the dollar

With the Federal Reserve Bank almost completely out of room to cut interest rates further, and the economic environment still looking very grim, focus is turning to the likelihood that the Fed will pursue a 'quantitative easing' policy to try to support the economy.

With the Fed's announcement that it plans to buy government-sponsored enterprise debt and mortgage-backed securities, this policy has arguably already started.

It could, however, be taken further with a large outright purchase of treasuries or even corporate bonds by the Fed.

As interest rates get close to zero, then less conventional policy measures become more important. The Fed has already moved to inject unprecedented levels of liquidity into the financial system, by increased lending to banks and primary dealers, extending loans to non-depositories, and by buying commercial paper. It has also dramatically increased the size of its swap programme with overseas central banks in order to try to alleviate the shortage of dollars overseas. The Fed now has swap agreements with 14 overseas central banks.

The aggressive moves to add liquidity have seen the size of the Fed's balance sheet explode. This is set to grow much further as the Fed buys up to $100 billion of GSE debt and up to $500 billion of GSE mortgage-backed securities over the coming months.

It seems very likely that the Fed will become more explicit on its move towards quantitative easing, but will such a move drive the dollar down?

The monetary model of exchange rate determination suggests it should. This view of exchange rates argues the exchange rate is merely the price of one country's money in terms of another.

So if the supply of one is growing faster than the other, the exchange rate will weaken in proportion to the relative growth rates. Taking this at face value would suggest that the dollar is set to fall rapidly when considering that money supply in Japan has remained stable and in the euro area it has only increased a relatively small amount.

However, for the monetary model to work, it requires several assumptions to be made. Perhaps the most important of these is that the demand for money function should be stable.

In the original quantity theory of money, it is assumed that the velocity of circulation of money (the number of times the money stock turns over in a year) is stable. The monetary model of exchange rates is essentially the international version of the quantity theory, and also relies on a stable velocity.

In March 2001, the Bank of Japan adopted a quantitative easing policy to fight deflation. The central bank provided excess reserves into Japan's banking system and committed to maintain this policy as long as inflation did not go up.

Initially, the introduction of quantitative easing in Japan caused the money supply to increase. However, despite the very large increase in the monetary base, the yen was relatively stable during the period and only starting to decline once global growth really picked up in 2005. From then until mid-2007, the yen was increasingly used as a funding currency in carry trades, and this tended to drive it lower.

Note, however, that Japan was running a large current account surplus throughout this period, and the global economy was relatively strong. The US continues to run a very large (if shrinking) current account deficit and the global economy is very weak.

The Japanese experience may be of only limited relevance for the US.

The impact of quantitative easing on the dollar will largely depend on how effective it is. One of the measures of success would be if long-term yields fell in response to Fed buying.

If this helps the US economy recover ahead of others, then this may attract capital inflows into the US and support the dollar.

However, should quantitative easing undermine perceptions of US sovereign credit quality, this would be a dollar negative.

Should quantitative easing fail to revive the economy, then more radical policies may be considered.

This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.